Odd Lots - Episode 2: Under the Hood of the $8 Trln Corporate Bond Market

Episode Date: November 16, 2015

(Bloomberg) -- It's definitely big and it might be broken. It's the bond market! The corporate bond market, that is. In the second episode of Odd Lots, hosts Tracy Alloway and Joe Weisenthal talk corporate debt with Chris White, the creator of a Goldman Sachs bond trading platform and a longtime market structure specialist. We learn about the difficulties of shaking up an $8 trillion market that has so far proved stubbornly resistant to change. We also hear why White stopped calling internal meetings at Goldman, and discover the difference between "two-minute guys, two-year guys and 10-year guys" at the storied investment bank.See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa, play the podcast OddLots on Amazon Music. Welcome to this week's Odd Lots. I'm Tracy Alloway, executive editor of Bloomberg Markets. And I'm Joe Wisenthall, managing editor of Bloomberg Markets and the co-host of What You Miss. It's Monday, November 16th, and I want to talk about bonds, corporate bonds, to be specific. So I'm really excited about this episode because I basically, know nothing about bonds. I know that when bond prices go down, yields go up, and vice versa. And I know sometimes credit quality is a factor and interest rates affect bonds. But beyond that, I'm a complete novice and I can't wait to just sit and learn from this discussion.

All right, but you know bonds are the things that companies sell to investors to fund their businesses, right? This I also know. Do you know it's an $8 trillion market in the U.S. alone? I knew it was gigantic. Do you know how bonds trade? I knew a little bit, but mostly what I know is what you told me the other day. Okay. So what I told Joe the other day is that bonds are traded in a really old-fashioned way still. So when you think of buying and selling stocks, for instance, it's usually pretty easy to do it. Investors large and small can do it just with the click of a button.

When it comes to buying and selling bonds, it's much more difficult. You actually have to pick up the phone, call a dealer at a big dealer bank, figure out price, size, and do the transaction that way. It's much less electronified. And part of the issue, too, is that everybody knows what a share of Microsoft is. There's one share of Microsoft common stock. But on the other hand, a company like Microsoft could have numerous different flavors of bonds, different years when they mature and stuff like that. That's right. And so there isn't like a single Microsoft bond that you could just trade. It makes trading much, much more complicated. But there are other factors underlying the bond

market's resistance to change. And we're going to talk about those factors today. And here to talk with us about them is Chris White, a former vice president at Goldman Sachs, and someone who, as we're about to learn, has had a lot of firsthand experience with the bond market and forcing through change on the market. Trying to bring it into the modern era. Exactly. So, Joe, I want you to sit back, relax, and try to learn something. So, Chris, tell us about your background in this space. So I've been working in electronic fixed income business development for about 13 years. I used to be a bond salesman, and then I was an equity arbitrage trader. For the past 10 years, I've been working on the dealer side.

I would say the general responsibilities for my role were to help the credit market-making businesses modernize. So I did that for Barclays and Lehman Brothers when we integrated, and then Goldman for the past five years, and I just recently left. So let's talk about modernizing. the corporate bond market. Walk us through the way that the bond market trades now or has traded historically. Is it fair to call it old-fashioned? No, it's set a stage that I think all markets go through. There are three major stages to markets. The first stage is a physical market in which human beings are directly interacting with each other in order for the market to work. And then what we're seeing in a lot of financial markets is what I call the hybrid stage, which is a

human beings interacting with each other through screens, and that's really where some of, or a lot of the fixed-income markets are going right now. And then you have the final stage that we're seeing in more electronically traded markets. I call them automated markets, where you're really having algorithms interact with algorithms, and that's where you get high-frequency trading in FX and rates and futures. But where we are from the bond market standpoint is I think we're really transitioning from stage one to stage two. So something like the stock market would be probably at stage three in your mind? There are areas of the stock market that's at stage three.

And I think that what gets confusing for a lot of people looking at markets is they tend to look at them with a sort of a one-size-fits-all and an inevitability around where the markets are going that I would say, I call it sort of like a sky net sort of view that eventually will, the machines will run everything. And I find this fascinating because, We have, I think, a great case study in the internet, and we look at the internet right now and we see that not everything is gone to a fully automated solution. It's not because of regulation. It's not because of some sort of laws around it, except for, I believe, the science around how markets work. All right. Now on bonds, even if you don't think the market is old-fashioned, it's difficult to argue that it's not at a later stage in its development than the stock market in terms of electronification. Why is that?

Well, I believe in a theory around size. I think that size has a really huge impact in the way systems work. And the best analogy that I can make is in the island of Manhattan in 1850, you had about a half a million people living here. But over the next 50 years, the population tripled. So by the end of the 19th century, you had one and a half million people living on the same space. And that necessitated the development of a subway system.

So in 1850, we don't need a subway system, but you can see with more people in a condensed space, you need a piece of architecture that's going to allow the city to function more optimally. What we've seen in the equity markets, the FX markets, futures markets, has been massive growth in terms of the outstanding size of the market, necessitating the delivery of architecture in the form of technology. We have not seen that growth until the past really six or seven years post 2008 in the bond market. And so now what you're getting is a market that's exploded in size without modernizing. Now, this brings us seamlessly to our next point, which is that in addition to worries over the way bonds have historically been traded, that has fed into worries about liquidity in the market. And this is basically the ease of trading bonds. And the idea here is that liquidity is low. You can't buy or sell bonds without heavily impacting the price.

And that could be a problem because we've seen the market explode in size and so many people buy these things. If everyone decides to head for the exits all at once, we could have a liquidity crisis, basically. I think that there's a huge misunderstanding around what liquidity really is. I think this misunderstanding is pervasive across almost all conversations that I hear about it. it starts really at the beginning, what do you believe liquidity is? And liquidity is subjective. It's like beauty. Right.

So you can't really define it, though I think there are some metrics we could probably use where you could at least get close to it. Where I think the liquidity debate starts is, do you believe that liquidity is a naturally occurring resource that can be harvested if you network a market? Or do you believe that liquidity is an unnatural resource? and a service that must be provided by someone. So basically the idea of whether or not you should pay for your liquidity. Well, if you think it's a natural resource that you can just harvest if you network the market,

then you're going to believe that if you use technology in the right way, liquidity will just show up. And what I find fascinating about this is that theory has never been proven in not only any of the financial markets, it's never been proven in any market ever in the history of markets. I recently was participating in a discussion around this, and somebody said when talking about liquidity, that the bond market, once technology hits, is going to function more like Uber. Right. And what I found really interesting about that is Uber doesn't eliminate the necessity for the person

wanting transportation to pay for the ride. It just makes it easier. So we're not Uberizing any of the. markets per se and and and moving to a world in which you don't need a transportation provider because hey I just am able to communicate with other people who happen to be going the same way as me and therefore my transportation needs are met I think the the perfect analogy for the networked liquidity theory is what you're really saying is if I had to go somewhere I'm

going to rely on hitchhiking as the vehicle what do you think about liquidity concerns in general though Do you fear that sort of worst-case scenario where interest rate rise and everyone tries to head for the exits at the same time? Not necessarily. That's actually the hurt effect has never been proven in markets. I think that what we're really dealing with and with most markets deal with is a perception problem. And perception has led to stampedes before. So we haven't put in the fixed-income markets, I think, things that would reduce the perception that there could be a massive run for the

exits. One of the things that was discussed recently and dismissed by a lot of large asset managers is a provision that would be put in where they would have to hold extra cash. And what that would do is if they had a lot of redemptions, people wanting to get out of their funds, instead of them having to actually sell bonds and create this mass effect that everyone's worried about, they could just respond to those redemptions with cash on hand. Right. But that hasn't been enacted as a policy. But I think just putting something in like that may just make people feel more at ease that this theory might not come to pass. Now, when you were at Goldman, you started something in the bond market space called G Sessions, an electronic bond trading platform. Nowadays, we've seen dozens of these things come to market.

Bloomberg also has electronic bond trading capabilities. What was the idea behind it? And would you call it successful? Yeah, well, the G Sessions platform, you know, I thought about it and created it at Goldman because I've been looking at the liquidity issue in the bond market for quite some time. I know it's in vogue now, but back in 2009, I was really looking at this and I stumbled across a piece of market structure history when they were dealing with a similar liquidity issue in equities. There was a really fantastic platform created. It was the first darkpool, something called ITG posit. And what basically G Sessions comes from is that philosophy. And what the philosophy is is that you can create a more efficient market if you actually slow things down. And it's something called periodic trading or point in time trading. And we see this a lot in systems not only in financial markets.

We also see it in systems outside of financial markets. If you've ever used the gilt shopping site, Tracy, I don't know if you ever have. Unfortunately for my credit card balance, I have. Right. So how does that site work? That site works. They have periodic sales of designers, and you kind of get an advance notice of what sales are coming on, and then you can be there when the sale happens and hopefully snap up a pair of shoes or something.

Yeah. Or 10. Yes. So, you know, guilt, if you know the origin of it, it started in response to the 2008 sort of economic crisis, where you had all of these high-end designers who had a tremendous amount inventory and as you know with fashion you're always building new things that you want people to buy so if your old line is sitting on the shelves how do you get rid of it right but how did you get rid of it in a way that doesn't hurt your brand so guilt really addressed that with a periodic flash sale that preserved the brand made it very lucrative not only for the people looking to

get these these items but also made it really lucrative for the designers themselves because they were able to control the amount of inventory that they are selling in these flash sales each time. I say that to say that there is a science behind how markets work, and you can see it both in financial markets and outside of them. So with G Sessions, we were trying to harness that science by basically creating what's called temporal consolidation, or that's a fancy way of saying, everybody doing everything at the same time, there could be benefits to trading both on the people seeking liquidity and us as a liquidity provider. Right. So I remember you would essentially have sort of sales of bonds that were pre-advertised and then people would know what was going to kind of come on the

platform and they could be there at the same time and you'd create a sort of point of liquidity. However, Goldman kind of backed away from the platform, right? Can you kind of explain what happened there and maybe walk us through how investment banks are dealing with changes to the bond market in general. You described it pretty well. I mean, I think it's, we could call it the guilt for bond trading where we would pre-announce when a bond was going to trade and then see how many buyers and sellers we could get to participate in the session, what we were calling it. I think the issue that Goldman was having with G. Sessions as a platform in general was actually pretty commonplace, you know, for many of the investment banks, especially the ones that are well

established and very successful like Goldman, where the benefits associated, with change do not necessarily outweigh, in fact, in no way outweigh the benefits associated with remaining the status quo on big successful businesses. So I felt as the inventor of the system, I was constantly having to defend the purpose of the system to people who had built careers and had made far more money than the system was making, which is totally understandable. I'd say that the best way I can describe what happened is similar to what happened to Kodak, when the digital camera was introduced. They still hung on to a business model in which they would be processing film.

However, Kodak now doesn't exist anymore because they didn't see where the world was going. So this is the idea that banks have bond traders who make a lot of money for the bank by essentially acting as middlemen for bond trades. So why would they want to give up that business? Well, I think that it's really, I think an easier way for people to think about markets is not to think of markets as systems of information, but to think of markets as cultural institutions. And they become cultural institutions because behaviors are institutionalized by the repetitive nature of actions. So then you start to believe that the market works this way, and that's your belief system

around how things should go. And so the belief system for many of the existing bond traders is that the way that this market functions best is if for every trade, I'm on the phone with a customer, and I'm providing them liquidity directly in a bilateral fashion. The problem now, though, to go back to what we were talking about earlier, is that that sort of cultural belief system can service a market that's maybe $2 trillion to $3 trillion in size, which is where we were back in 2002, 2003. This market today is over $8 trillion in size and screaming towards $9 trillion.

So this sort of old school, I need to be on the phone all the time for every single trade simply cannot service this market the same way that a horse and carriage in Manhattan in 1890 was not the preferred method of transportation because there were just too many people in the city and you couldn't move around. Right. We're going to wrap it up slowly, but we've seen a lot of banks, Goldman included, claim that there are technology companies now. We've had Lloyd Blank finds stand up multiple times and say, we're a technology firm. coming from inside the bank and being on the forefront of some of its technological endeavors, what do you think about that?

I think it's very interesting branding. I mean, some of these businesses are making so much, or have made so much money historically that even the best case scenario around a technology solution would never equal, you know, what these businesses make year over year. So I think that a lot of the saber rattling, not just from Goldman, but from other dealers around being a technology company are really designed to make investors feel more comfortable with the longer term strategy. Hey, we're not big risk takers. We're trying to actually develop solutions that have higher margins and are more sustainable. I mean, somebody who's actually

acting on that instead of just talking about is actually ICAP. Icap is an interdealer broker. They, their business is basically to broker trades between banks. And a lot of that business has been going the way of electronic systems. And ICAP has made a very large, bet that voice negotiation of trades between banks is going to become extinct. That's why they've sold it to Tallott's their rival. And they're putting all of their chips on the table and betting on actually electronic systems being the future of dealer-to-dealer trading. All right. Speaking of cultural and technological change, Chris, you once told me something really interesting about meetings at Goldman.

Well, yeah, I think it was what we were talking about was just basically, how banks were handling innovation, and I think my response to you was, eventually I stopped calling meetings. Because in terms of talking about innovation and resources and strategic planning, I could never go into a meeting without knowing exactly what everyone in the meeting was supposed to say. And I was pretty much directed to behave this way, which was, before you go into a meeting, make sure you have individual bilateral meetings with every person who's coming into that meeting beforehand. And so it became really difficult, I would say, to be effective in a meeting because I don't think that they were designed to get anything done. They were really designed to make sure that everyone was protecting their own interests and doing it in a formal way. Did anyone notice that you weren't calling any meetings?

I think they were kind of relieved that they didn't want to say, hey, I want to have another meeting with you. Mainly because, you know, think of what my topic is in a meeting. I'm talking about change. I'm talking about something that may make someone uncomfortable, something that they may not understand on the surface. And I think that some of the best advice I ever got from Goldman was when I first arrived, somebody very senior took me aside and they said, there are two-minute guys, two-year guys, and ten-year guys.

The two-minute guys are people who have made so much money that they could retire in two minutes and it wouldn't make a difference to their bottom line. the 10-year guys are the people who know that they need to make a career out of the future of this business, and therefore they're going to be very invested in you. But it's the two-year guys. It's the people who in two years want to retire are going to be inertia for you. They're not going to want to see innovation because they want to see if they can clip a few more coupons before the music stops. It's a good way of putting it.

Well, it was prophetic in terms of the advice. It was really helpful for me figuring out where do you belong? Two minutes, two years, or 10 years, and then I was able to navigate a little bit easier in that way. All right. Since leaving Goldman, Chris White has founded his own company, viable markets, which is helping many, many different types of financial institutions to modernize their fixed income structures. Chris, thank you so much for being here. My pleasure, Tracy. All right, Joe, we just heard a whole bunch of interesting stuff. What did you learn?

That was totally fascinated. I'm just amazed at the extent of the complications of this problem and how difficult it's going to be to solve. Also, I'm never going to take another meeting again. All right. Thanks everyone for listening. I'm Tracy Alloway. You can follow me at Tracy Alloway on Twitter. And I'm Joe Wysethal. Follow me at the stalwart on Twitter. Please join us next week for another episode of Odd Lots. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gura. Join us every Saturday and Sunday for the new Bloomberg this weekend.

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